‘February Was As Significant As The 2007 Quant Meltdown’: Here’s What Goldman Expects For Volatility

I’m a big believer in the idea that part and parcel of suppressed vol. in 2017 was a Pavlovian dynamic that optimized around itself until “buy the dip” was transformed from a derisive meme about retail investors’ propensity to act irrationally to an actual “strategy” that was, right up until 2018, not only viable, but in fact infallible almost by definition.

Generally speaking, I try to combine the “fourth wall” framework espoused by Deutsche Bank’s Aleksandar Kocic with BofAML’s work on “BTFD autopilot” on the way to formulating something that approximates a coherent narrative about how we got to where we are.

If you’ve followed BofAML’s work on the Fed “put” and the BTFD mentality, you know they’ve spent a lot of time talking about how it’s become self-feeding.

In short, the two-way communication loop between policymakers and markets (and that’s the Kocic reference) became a self-fulfilling prophecy over the past couple of years. Markets became so conditioned to policymaker intervention and dovish forward guidance at the first sign of trouble that no one saw any utility in waiting around for it anymore. After all, if you know it’s coming, why wait on it? Why not buy the dip now?

Here’s how I put this in February:

Part and parcel of that dynamic is the idea that the central bank put has become self-sustaining – it runs on autopilot. Why wait on dovish forward guidance (or any other signal from the monetary gods) to buy the dip when you know with absolute certainty that in the unlikely event a drawdown proves to be some semblance of sustainable, policymakers will calm markets? If you know it’s coming, well then you should buy the dip now. This becomes a recursive exercise as everyone tries to frontrun everyone else and before you know it, dips and vol. spikes are mean reverting at a record pace as the prevailing dynamic optimizes around itself.

In a recent piece, BofAML reiterated that, citing their own previous research on the way to updating their BTD chart:

Here’s some of the accompanying color from the bank for anyone who might have missed it – essentially, they argue that BTFD either failed this year or at the very least, nearly failed:

The 5-Feb-2018 trigger seems most similar to the 21-Aug-2015 shock (China slowdown scare), which lost 1.93% upon liquidation at the end of the 20 trading day window and ultimately took 52 days to fully recover (Chart 8 and Chart 9). Looking at the recent 5-Feb shock, we are 43 days in and the market is down an additional 1.63%. However, in comparison, after 43 days into the Aug-15 shock the S&P had actually recovered about 2%. While in ‘15 Chair Yellen supported markets by announcing a delay of rate hikes due to concerns about China and equity weakness, today few expect Chair Powell to step in to support stocks. Our trading rule triggered for a second time in 2018 on 22-Mar, and as of 6-Apr we are 13 days into the 20 day investment window. At current prices, the trade has lost 2.13%. In order for the dip to fully recover within the window, S&P E-mini futures (ES1) would need to cross 2,802.50 by 19-Apr, over 7% above 6-Apr’s closing level of 2,605.75.

That’s a bit dated, but you get the idea. The bottom line from BofAML’s perspective is that the very fact that the spell has been broken means a return to the low vol. regime we saw last year isn’t likely.

“Importantly, even if US equities do end up recovering to set new highs in 2018, perhaps on the back of a strong earnings season, simply breaking the trend of rapid recoveries (and the Pavlov BTD mentality), should prevent a return to the 2017 bubble lows in volatility,” the bank concludes, in the note cited above.

Still, I’m a believer in BofAML’s contention that a reversion to last year’s anomalous calm is unlikely precisely because the spell has been broken. The psychological overhang from February is probably going to be sufficient to keep retail investors from going full-BTFD-retard or, more politely, to make them hesitant to act as the “marginal equity buyer” (to quote a recent JPMorgan note).

As it turns out, Goldman’s Rocky Fishman (he used to pen a lot of the “feedback loop” notes that informed our own “doom loop” thesis when he was at Deutsche Bank) agrees.

“We believe the volatility spike in early February was a significant event for investors, perhaps as significant as the Summer 2007 Quant meltdown,” he writes, in a note dated Wednesday, before elaborating as follows:

Beyond the mechanical impact of volatility on risk taking, there is potential impact to sentiment. The spike in realized volatility was large enough for investors outside the equity market to take notice and could lead to a reduction in risk-taking appetite on the margin in the coming months. The February VIX spike was yet another symptom of the market fragility created by lower liquidity following periodic flash crashes in stocks, ETFs, and Treasuries (which themselves had a 8bp move in the 10Y yield in 4 minutes on 5-Feb). We believe that a shift towards risk reduction and expectation of higher volatility is likely to change the trading dynamics in 2018. We expect volatility to increase but the market to remain range-bound as investors digest the new environment.

You’ll note that he references a number of important points there including the panic bid for USTs that sent 10Y yields plunging just after 3:00 pm during the February 5 meltdown, the risk that “markets themselves” could cause or at least exacerbate the next big drawdown and the impact February’s events had on vol.-sensitive strategies.

On that “markets themselves” risk, you can read some excerpts from Goldman’s take in the linked piece, but allow me to quote Marko Kolanovic on that for a moment. For anyone who missed it, here is the bit from his latest note on the “Uberization” of markets – I think you’ll see why it’s germane:

Liquidity: Risks of Market “Uberization”

We have noted in the past that a combination of computerized sellers, and computerized market makers poses a threat to equity price stability. As volatility increases, systematic investors have to sell, and at the same time market depth as provided by electronic market makers quickly disappears. For instance, S&P 500 futures market depth dropped over 90% during the February selloff. What is the reason for such a dramatic drop in liquidity? The most important driver is likely the increase of volatility (e.g. VIX), given that many market making algos (as well as business models) were calibrated during the years of low volatility. As these programs don’t have an obligation to make markets and are optimized for profits, they likely adjust quotes and reduce size in order to maximize their own Sharpe ratio. Other factors likely played a role as well: the increase in short-term rates (e.g. LIBOR), increase of exchange margin requirements, index fund outflows, and risk capital being diverted towards cryptocurrency market making. Full electronification of the market making industry has never been tested in a recession environment. Given that financial markets are a critical part of the economy’s infrastructure, perhaps more attention should be paid to the risks posed by the Uberization of financial markets. The analogy between market making and Uberization is as follows: when there are normal market conditions, the amount of liquidity (cars available) is more than needed and market transaction costs (fare) is low, thus benefiting market participants. However, when there is a volatility shock (heavy traffic, weather) liquidity quickly disappears (i.e. fares can surge to unreasonable levels). In the case of a car ride, one can simply ignore such a surge in price, postpone the trip, or fall back to public transport. However with financial markets, certain participants have to transact (e.g. systematic strategies, option hedging, leverage constraints, algos trading headlines). This results in significant intraday volatility and causes damage to investors’ confidence in the market. Human market makers (the analogy of regulated taxi services or public transport) were to a large extent dismantled over the past decade, so there is hardly any alternative liquidity back-up. These risks previously manifested themselves as ‘flash crashes’ in single stocks and indices. However, equally damaging for investor confidence are what we see now as ‘slow moving crashes’ that can last several hours as was the case recently with some large stocks and market segments (e.g. Caterpillar ~11% intraday drop on April 24th).

That is a critical point and it’s one that none of the humans behind the machines want to talk about. While it’s probably unfair to lay all the blame for an absence of liquidity provision in a pinch at the feet of the machines, there’s no question that modern market structure has increased the risk of flash crashes and made it more likely that liquidity will suddenly dry up at the worst possible time.

Ok, so getting back to Fishman’s latest, Goldman attempts to predict the evolution of realized vol. using expectations for changes in the economic environment or, more simply, the point is to assess whether volatility in the econ is likely to mean higher sustained realized equity vol. Here are their predictions:

We expect baseline monthly SPX realized volatility to average 13% in 2H2018 based on GS Economic forecasts, up 6 points from 2017, but below the 19% realized year-to-date. This implies 15% volatility for full-year 2018.

While far from our core view, stress testing our model shows a two standard deviation economic shock would lead to SPX realized volatility of 32%, up 13 points from recent levels

I won’t subject you to the specifics of the model here (i.e., how they use the econ to inform their projections for volatility), but Fishman sums it as follows and there’s a helpful accompanying table with a handy “how to this” guide on the bottom:

While we expect moderation in growth to drive an increase in volatility for 2018 and 2019, our economists broadly expect growth to remain at above-average levels. It is therefore unsurprising that our estimates for volatility remain below the average levels of volatility observed from 2000 to present.

The tie that binds here (if you will), is that the upside risk to Goldman’s projections comes from the hit to sentiment following the February vol. spike.

That dovetails with BofAML’s contention that the recent “failure” of BTFD has dented investor confidence in the viability/durability of the low vol. regime.

Because that regime was in part a manifestation of a psychological predisposition that became self-fulfilling, a shift in the underlying sentiment is in and of itself sufficient to ensure that it won’t be fully restored.

Writing about a subject is the best
way to educate yourself about it, and when I flick through past work I remember how much
they taught me, if no one else. Mainly they taught me that I didn’t know very much. But they
also taught me that most other people didn’t know much either. Thus, some key themes
which stand out include the illusory control of policy makers, the presumed knowledge of
those looking to them to actively do good, the ease with which we fool ourselves, and how
best to protect capital in the face of such unavoidable uncertainty. -- Dylan Grice